Diversify Or Concentrate?

Should you spread your investments around or focus on your favourites?

Some 2,200 years ago, the Chinese General Xiang Yu crossed the Yangtze River with an army of 20,000 men, aiming to defeat the rival Qin dynasty.

Having landed, Xiang ordered his men to prepare three days worth of food rations. Once they had done this he had their boats set on fire and destroyed their cooking equipment! By doing this Xiang gave his army two options; win or die.

Some choice you might say, but it worked! They swiftly routed the much larger Qin army and after his final victory Xiang was crowned Emperor of China. Of course had they lost then Xiang would probably have been killed by his own men for his folly!

But what does this tale have to do with investing? Well, it turns out that some investors follow a similar policy to Xiang, albeit one with lesser stakes. These investors deliberately restrict their options by focusing upon only a few investments, or even just the one ("betting the farm"), because this offers the possibility of superior returns (when it works).

Twenty options

Warren Buffett has an interesting idea which causes investors to concentrate their firepower. He suggests that investors should assume that they have been given a punch card with twenty slots and every time they make an investment one of their slots is used. When the last slot is punched that's it, no more investing for you.

The concept of an investment punch card is intended to concentrate the mind. But anyone who follows it literally will find that it forces them to hold just a few investments at any given time. Wonderful if it works, but a nightmare if it goes wrong.

Why we concentrate

Owning a very concentrated portfolio, one which contains a small number of investments, is a strategy employed by investors who want to increase their potential returns. But investors who do this must also be prepared to accept the risk of major losses.

The extreme example, like Xiang and his army, is to follow Mark Twain's Pudd'nhead Wilson and put all of your eggs in just the one basket. It's brilliant if it works, as anyone who put all of their money in Rockhopper Exploration (LSE: RKH) at the start of 2010 can tell you (they've made more than 500% on the year even after a heavy fall this Wednesday morning).

But had they put everything into a company which collapsed then they would have lost the lot! It's a dangerous strategy.

Many investors used to hold concentrated portfolios which mostly contained bank shares. Now put yourself in the shoes of such an investor whose portfolio in early 2007 consisted of four shares; HBOS, Royal Bank of Scotland (LSE: RBS), Bradford and Bingley and Northern Rock. How would you now feel having lost more than 95% of your total worth?

The second part of Twain's dictum is "… and watch that basket." If you concentrate to this extent you must keep a very close eye on your investment basket. Most of us are not prepared to take such a risk so we instead choose to hold many different investments.

Why we diversify

You diversify by splitting your wealth between different classes of asset, as well as within each asset class. The textbook diversified portfolio contains a mixture of shares, fixed-interest investments, index-linked investments, cash, commercial property, residential property, antiques, land, gold, jewellery, commodities and other things that can be bought and sold.

The intention of diversifying is that when the value of one asset class is badly hit your overall losses will be relatively small. Furthermore many events which produce falls in the value of some asset classes will also cause the value of other asset classes to rise.

A good example of this was seen at the height of the banking crisis in late 2008; investors' shares took a hammering but their holdings of government bonds rose in value as panic-stricken investors flocked to buy bonds.

Diversification is a defensive strategy; you reduce your risks by holding investments whose performances are not closely correlated with each other. For example, the prices of long-term bonds and shares have tended to move in different directions, which is why one of the major asset allocation decisions most investors face is what proportion to split between shares and bonds.

A few more points

A strong argument in favour of concentrating your portfolio, at least to some extent, comes from Peter Lynch who coined the term "diworsification." Lynch said that diworsifying occurs when investors have diversified their portfolios to such an extent that most of their investments have negative correlations with each other. So when one asset class goes up, another falls and the net result is that the portfolio tends to stagnate.

Watch that you don't fall into a diworsification trap, if only because monitoring several hundred investments is a lot of work!

Also keep an eye on your shareholdings; some companies become over-dependent on a major customer and will suffer badly when that customer decides to go somewhere else. Farmers know all about this problem as many of them have been clobbered by the supermarkets in recent years.

One of the best examples of this was seen ten years ago when Marks & Spencer (LSE: MKS) stopped buying clothes from William Baird. M&S was responsible for over a third of Baird's sales and the effect was pretty devastating.

Diversification is partly a response to the "unknown unknowns" that no amount of watching will help. But the prices of many financial assets are related via common factors like interest rates and gdp expectations.

"A strong argument in favour of concentrating your portfolio, at least to some extent, comes from Peter Lynch who coined the term "diworsification." Lynch said that diworsifying occurs when investors have diversified their portfolios to such an extent that most of their investments have negative correlations with each other."

Having recently read 'One Up on Wall Street' Peter Lynch did use the the word "diworsification" but with respect to companies attempting to diversify (but in the process destroying value) by acquiring non-core businesses. The fact that his Magellan fund had a 100+ stocks is testament that he was a great fan of diversification as far as share portfolios go.

Diversification only really makes sense for a HYP, where you need to spread across different sectors to cover reduced or stopped dividends from a particular company or sector. Therefore keeping some of your income stream alive.

Other than that, Diversification (when talking about equities alone) for the sake of it seems to make no sense. You hold a share because you think it presents good value (better than the market average) - so in essence you think know more than most on this particular company. You can only surely put the required time into monitoring a small number of companies. To diversify away from your core knowledge base to protect yourself against losses, seems to me to miss the point. By seeking to minimise this risk, you will dilute your potential gains also. You continue reducing risk, but where do you stop ? Surely you reach the point at which, you are so diluted you are merely approximately matching the market average. Therefore why not just stick with trackers & improve your golf, instead of wasting precious time analysing something that someone else can do for you.

I think it depends on what you (or anyone else) means by 'diversification'.

Some mean randomly buying as many different assets as possible, or if not randomly then by some basic criteria (market cap and location, for example). I would rather say it spreads your risk rather than reduces it. With stocks you can still get burned if the whole market falls, though you do eliminate the risk of your investment going to zero.

But if you simply mean having your eggs in more than one basket, then I think that is a good thing. And I daresay, that's what the Magellan fund did, and that's what Berkshire Hathaway does.

So I would rather have ten great value stocks than one hundred random ones, though twenty or thirty great value stocks would be ideal.

One shareholding should not be allowed to become more than 20% of the portfolio.

Following the above guidelines, as Buffett says; holding more than 15-20 companies is not helpful because of the extra attention needed to monitor all the holdings, especially the time required to analyse their accounts during reporting season.

Medium-sized (FTSE250) companies should have their allowed weighting reduced by about one-third.Small-sized companies should have their allowed weighting reduced by about two-thirds.

If the portfolio is relatively small, then the above rules need to be relaxed so as not to create excessive dealing costs. In my early days, I would have about twice the weighting in half as many companies, relative to my current guuidelines.

Of course, diversification between asset classes is designed to reduce volatility whilst preserving profits. As noted above, putting all your eggs in one basket is a high-risk strategy - however closely you watch it - and most people like to sleep easy at night. It really depends on your personal objectives and character. For a more cautious, income-seeking investor, it makes sense to diversify the sources of income (interest on cash, bond coupons, share dividends, rent).

Neither did I until I made a life choice to give up the lucrative but depressing 'day job' ;-)

I just so happens that I don't have to watch my myriad baskets like a hawk all day myself because my Stop Orders do that for me, but I was reluctant to use the dreaded S-O phrase (again) here on TMF in case anyone thought I was obsessed!

We don't think you're obsessed Tony - we know you are! (;-0) Best Regards, and good luck with your business, Robinn.On topic: Buffett said that diversification is for those who don't know what they are doing, and they should buy a tracker fund. He has quite a few stocks himself, although nowhere near as many as Lynch and Bolton had. Fifteen to twenty seems about right to me; I try to run the winners and sell the losers, as Peter Lynch said doing the reverse is "Watering the weeds!"

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